Capital Southwest Corporation — Form 10-Q
Reporting period: Quarter and nine months ended December 31, 2022. Unaudited. Capital Southwest is an internally managed business development company (BDC) providing debt and equity financing primarily to lower-middle-market companies.
Financial performance and position
| Metric | Three months ended Dec. 31, 2022 | Year-over-year change | Nine months ended Dec. 31, 2022 |
|---|---|---|---|
| Investment income | $32.8 million | Up 46.9% | $82.1 million, up 34.2% |
| Net investment income | $19.4 million; $0.62 per share | Up 63.2%; $0.51 per share in prior year | $46.3 million; $1.64 per share, up 51.0% |
| Net realized and unrealized investment result, net of tax | Loss of $16.5 million | Compared with a $0.7 million gain | Loss of $31.4 million |
| Net increase in net assets from operations | $2.9 million; $0.09 per share | Down 76.5%; $12.6 million in prior year | $14.9 million; $0.53 per share, down 35.6% |
Quarterly investment-income growth chiefly reflected a larger debt portfolio and higher interest income. Higher borrowing costs partly offset this: quarterly interest expense rose 70.5% to $7.9 million. Management attributed the increase to higher average borrowings and higher borrowing rates.
At December 31, total investments at fair value were $1.150 billion, versus $936.6 million at March 31, 2022; the portfolio included 82 companies. Net assets were $561.5 million and NAV was $16.25 per share, compared with $420.9 million and $16.86 per share at March 31. The nine-month NAV-based total return was 6.47%; the market-price-based investment return was negative 20.95%.
Cash and cash equivalents were $21.7 million. The company reported $174.4 million of available credit-facility borrowings and $159.7 million of unfunded portfolio commitments. For the nine-month period, operating activities used $193.6 million, primarily reflecting investment originations; financing activities provided $204.1 million, and cash increased $10.3 million.
Debt principal outstanding totaled $619.0 million: $225.0 million under the credit facility, $104.0 million of SBA debentures, $140.0 million of January 2026 notes, and $150.0 million of October 2026 notes. The company reported 229% asset coverage and compliance with credit-facility financial covenants. Credit-facility commitments were increased to $400 million. The board declared $0.57 per share for the December quarter; on January 25, 2023, it declared $0.58 per share for the quarter ending March 31, 2023.
Material changes and portfolio
- Quarterly investment income rose, while investment gains turned to substantial losses; accordingly, net operating results fell despite higher net investment income.
- The portfolio grew from $936.6 million to $1.150 billion in fair value since March 31. First-lien loans represented 83.0% of portfolio fair value; 96.7% of the debt portfolio was floating-rate.
- Non-accrual investments declined to 0.3% of portfolio fair value, from 1.5% at March 31. However, investments rated below expectations (ratings 3 and 4) totaled 4.9% of the debt portfolio at fair value.
- Share issuance funded growth: the company raised $44.1 million net in a November underwritten offering and $130.0 million net through its ATM program over nine months. Common shares outstanding increased to 34.6 million from 25.0 million at March 31.
Outlook, risks and unusual items
Management said available cash, investment cash flows and credit-facility capacity were adequate for needs over the next twelve months. No earnings or investment guidance was provided. Management highlighted inflation, supply-chain and labor constraints, rising rates, possible recession, geopolitical uncertainty, COVID-19 effects and LIBOR transition as risks to portfolio-company performance and valuations.
Most portfolio investments are privately held and valued using significant unobservable Level 3 inputs; actual recoveries may differ materially from reported fair values. PIK interest accounted for 4.6% of quarterly investment income and is recorded before cash collection; it can contribute to distributions required for RIC tax status. A hypothetical 100-basis-point rate increase or decrease was estimated to change annual net investment income by up to $8.2 million, or $0.22 per share. The company had no interest-rate hedges.
Unfunded commitments increased to $159.7 million; outstanding letters of credit were $0.9 million. The filing reported no pending material legal proceedings and no material changes to previously disclosed risk factors. All investment assets are generally Level 3, and valuation estimates depend on company performance, market yields and other assumptions.
Important facts for investors to verify
- Whether portfolio-company performance, credit quality and the 4.9% of debt investments rated 3 or 4 have changed since December 31.
- Whether portfolio fair values and reported investment losses are consistent with subsequent borrower results and realized recoveries.
- How floating-rate income and rising funding costs affect net investment income, including the sensitivity of credit-facility costs to rates.
- Whether unfunded commitments, dividends and new investments can be supported by available liquidity without additional material equity issuance or borrowing.
- The effect of share issuance and distributions on NAV per share and per-share earnings.